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23 February 2013

The Spending Problem

Some critics of government would like services and regulations to be cut to the minimum—keeping modest defense and justice, but allowing everything else to devolve to the market.

That's a wonderful utopian ideal. But we shouldn't let the best become the enemy of the good. That utopian ideal did not work in the time of Adam Smith, who favored reasonable regulations and expenditures for public goods like education. And it makes even less sense today.

Since that time, strong forces have pushed us toward more government. Here are two reasons, both relating to wealth:

Population density. The world's population has doubled, and doubled, and doubled again. That growth has now slowed, but we have far higher population density and it will continue to increase in cities. People living on top of each other produce both positive and negative externalities. Since Pigou, economists have demonstrated how government intervention can deal with negative externalities through taxes, regulations, and so on.

Ronald Coase is often credited with discovering that the market, left to its own self-interest, could solve the problem of negative externalities without government—assuming property rights and low transactions costs for defending those rights. But Coase explicitly rejected this notion, writing: "The world of zero transactions costs has often been described as a Coasean world. Nothing could be further from the truth." -- Ronald H. Coase, The Firm, the Market, and the Law (Chicago: University of Chicago Press, 1988, p. 174).

Let us imagine we could magically bestow property rights and other human rights on the citizens of Beijing, as well as an impartial judicial system. One fundamental human right is the right not to be injured by others without cause. Beijing residents currently experience terrible health injuries from car and truck pollution. Even with rights and a reliable legal system for defending them, who is the citizen of Beijing going to sue? No single car or truck is the cause of the injury, but only in combination. The transactions costs for suing all the drivers would be enormous. The market cannot solve this particular negative externality. There is a need for government regulation or taxing to discourage activities that produce negative externalities when no property rights exist (the atmosphere) or where transactions costs are high.

Enlarging moral sentiments. The rise of wealth also enhances our abilities to connect with other human beings, as shown by Benjamin Friedman's, The Moral Consequences of Economic Growth (2006). Rising wealth led to the fall of slavery, the rise of women's rights, and the invention of the safety net. The old, the sick, and the unemployed are not forgotten or shuffled aside. There are always significant moral hazards, of course, leading to the notion of "welfare queens," and the backlash against the state.

The reality, however, is that most Americans strongly favor environmental and safety nets. Rather than spending cuts, most Americans want spending increases in these areas, as shown in this recent Pew survey:

It is not a moral failing that the American people should want to clean the environment and help others. The key problem is that people want such benefits without being able to pay for them. The PEW questionnaire doesn't help. The question should be: "How much additional tax would you be willing to pay to increase X spending?"

Another key problem is that the total effects of all these incremental increases in spending or regulation are rarely considered. Like a frog in the pot of water, a little more heat doesn't matter, but the overall effect of incremental increases in heat could be destructive.